Business Succession: Transitioning to the next generation

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Transitioning Family Businesses

Statistics demonstrate that family owned businesses are the lifeblood of Australia’s economy. For example:

  • around 70% of Australian businesses are ‘family owned’;
  • around 60% of family businesses have two or more generations of family members involved in the family business; and
  • the average of age of the owners of family businesses is 58, with 25% of those owners being 65+ years of age (according to the MGI Australian Family and Private Business Survey 2013).

In order to ensure the long-term ongoing success of family owned businesses, it is critical that the current generation can either sell their business, or effectively transition their business from the current generation to the next generation.

This article focuses on the legal issues to consider in transitioning a business from one generation to the next.

How is the Business Currently Structured?

The way that a family business can be transitioned, and what steps need to be taken, depend on the current legal ownership structure of the business. Business structures come in all shapes, sizes and levels of complexity. However, three of the most common family business structures that we see are:

  • (personal ownership) a company owning the business, with the shares in the company owned personally by family members;
  • (trusts) a family discretionary trust owning the business, with the trust controlled by the family; and
  • (company owned by trusts) a company owning the business, with the shares in the company owned by family discretionary trusts (with those trusts being controlled by the family).

The specific existing structure of a business will determine what legal mechanisms are available to the owners to transition the business to the next generation.

Where There’s a Will There’s a Way?

Where businesses (or shares owned in businesses) are held in personal names, one mechanism for transitioning the business is via the existing owners last will and testament (‘Will’). While it may seem relatively simple to transition a business in this manner (and generally, without any tax or duty consequences), there are a few significant downsides. Because ownership only passes on the death of the current owner, this means that:

  • there is no certainty that the ownership of the business will pass to certain family members (as Wills can generally be amended at a later date);
  • there is no certainty about when the change in the ownership will occur; and
  • an aggrieved family member who did not get their ‘fair share’ of the family assets may challenge the wishes of the current generation by making a ‘testator family maintenance claim’.

Also, where a business or equity interests in a business are owned by discretionary family trusts, transitioning that equity via a Will is not possible.

Due to the comments set out above, it is usually either sub-optimal or not possible to transition equity in a business using a Will.

Tailored Transition Options

There are many other legal mechanisms to transition a family business, which generally cater for a more robust succession solution than relying on the Will of the existing owners. These mechanisms are set out in the table below.

Each of the options set out in the table above have different practical, legal and tax consequences.

Preserving Harmony

It is important to consider what legal mechanisms need to be put in place to ensure that the business will operate harmoniously going forward. The most appropriate option will depend on multiple factors, including:

  • the dynamic between family members;
  • whether any non-family members own equity in the business;
  • whether all, or only some, family members are involved in the business;
  • whether the current generation wish to be involved in the business after the transition;
  • the future plans of the next generation, including the extent to which they intend to be involved in the business; and
  • where a business is already co-owned, the relationship between co-owners (including the terms of any existing co-ownership agreement).

It is important that the succession plan for the business, and the associated legal mechanisms which implement it, take into account the factors set out above. Failing to address the practical matters set out above will inevitably create risk that the succession process will not go according to plan.

Clearly Defined Interests vs Flexibility

Where existing business interests are owned via family discretionary trusts, it should be considered whether that structure is appropriate, post-transition. For instance:

  • do family members require clearly defined equity that will pass over time? (e.g. a staggered ‘sell down’ from the current generation to the new generation); or
  • is the family happy to adopt as a structure that does not clearly define equity between family members (e.g. a single family discretionary trust, where control passes from the ‘current generation’ to the ‘new generation’).

Tax Consequences

Any proposed changes to the current structure must consider the tax or duty consequences of those changes. On one hand, making changes to the current structure could trigger adverse tax (e.g. capital gains tax) consequences and duty consequences. However, on the other hand, there may be rollovers, concessions (e.g. the small business CGT concessions) or exemptions available to shield against adverse tax consequences.

In some circumstances, no tax concessions or rollovers may be available, and making a change to the current structure could trigger a large tax bill. In those circumstances, consideration needs to be given to what other kinds of ‘legal mechanisms’ could be put in place to achieve a similar outcome, but that do not trigger unpalatable adverse tax or duty consequences. In the context of the control of a family discretionary trust, this could involve ‘hardcoding’ certain procedures into the trust deed regarding the transition of control.

Family Constitutions?

Finally, any family business (particularly one transitioning from one generation to another) should strongly consider putting in place a ‘Family Constitution’. A Family Constitution is set of rules developed collectively by a family group that defines and emphasises family values, decision making principles and how inter family conflicts should be resolved.

A Family Constitution is generally not a legally enforceable document (in contrast to trust deeds, co-ownership agreements and company constitutions). However, its strength lies from family groups addressing issues that are often placed in the ‘too hard basket’ and agreeing on a core set of family principles. As Ray Dalio (founder of the world’s biggest hedge fund) says:

“The most important thing for you to do is write down your principles to clarify them.”

Level 12, 360 Elizabeth Street,
Melbourne VIC 3000

Level 10, 580 George Street,
Sydney NSW 2000

Level 12, 360 Elizabeth Street,
Melbourne VIC 3000

Level 10, 580 George Street,
Sydney NSW 2000

Liability limited by a scheme approved under professional standards legislation.